Hedge Funds Generate Alpha but Take All of It

From Roger Ibbotson, Peng Chen and Kevin Zhu.

We analyze the performance of a universe of about 8,400 hedge funds from the TASS database from January 1995 through December 2009. Our results indicate that both survivor-ship and back fill biases are potentially serious problems. Adjusting for these biases brings the net return from 14.26% to 7.63% for the equally weighted sample. Over the entire period, this return is slightly lower than the S&P 500 return of 8.04%, but includes a statistically significant positive alpha. We estimate a pre-fee return of 11.42%, which we split into a fee (3.78%), an alpha (3.01%), and a beta return (4.62%). The positive alpha is quite remarkable, since the mutual fund industry in aggregate does not produce alpha net of fees. The year by year results also show that alphas from hedge funds were positive during every year of the last decade, even through the recent financial crisis of 2008 and 2009.

Comments

[Martin Knight]

My reading of the paper is that fees don't take all the alpha. Remember they're taking less risk than 100% stock funds (hence the name hedge) as shown by the beta. Fees take a little more than half of the pre-fee alpha. I doubt this will be true going forward however with the explosion in the number of hedge funds - this will grind down to nothing any advantage in talent. With the 2 and 20 fee structure an investor has little chance of beating the indexes even before taxes. I suspect most large investors will be much better off now buying and never selling quality staples like Nestle, Kraft, PG etc. and watch them compound tax free. That's certainly my strategy now they're fairly priced for the first time in years.